Verbose And Ill-Organized

A picture of a despondent looking floor trader was situated next to a file photo of Jerome Powell adjusting his tie on CNBC’s front page Wednesday afternoon.

The point was to make the connection between the December FOMC minutes and a swoon in US equities, which retreated on “fresh” hints of faster rate hikes and the prospect of balance sheet rundown. Expect to hear plenty over the next several months about “double-barreled” tightening, beginning later this year.

2018’s trials and tribulations live, not just in campfire ghost stories, but also in contemporary Fed policy, which many now assume will mirror the Committee’s stance from Powell’s first year as Chair, at least to the extent rate hikes unfold concurrent with balance sheet rundown. Remember, 2018 was no walk in the park (figure below).

Volpocalypse was a fleeting, technical drawdown made inevitable by the mechanics associated with the impossible rebalancing needs of the VIX ETP complex. That year’s Q4 mini-bear market, on the other hand, was a policy-driven nightmare exacerbated by communications missteps from Powell and an irritable president.

“Balance sheet” featured more than two-dozen times in the December minutes, including the following passage, which acknowledged market expectations for the onset of QT:

With the likely timing of the beginning of the removal of policy accommodation considered closer, market participants began to discuss how balance sheet policy might feature in the Committee’s plan for reducing accommodation when warranted, although expectations for the timing of the first decline in the balance sheet were diffuse.

“Diffuse” was a hilarious adjective to employ while describing the debate among analysts and traders over the onset of balance sheet runoff. One dictionary definition is, “Being at once verbose and ill-organized.”

Let’s hope Fed communications around QT aren’t similarly “diffuse,” otherwise risk assets might become… well, “ill-organized.”

I’m compelled to roll out the usual charts (above). As Harley Bassman is fond of putting it, “clever quants will say a statistically significant mathematical correlation doesn’t exist between money creation and financial asset prices, but who are you going to believe, them or your lying eyes?”

It’s probably fair to say the discussion around runoff (as detailed in the minutes) was more robust than some market participants planned for. That, despite Powell’s mention of the issue during the December press conference and Nick Timiraos’s attempt to further socialize it on Tuesday. The passage (below) appeared to contribute to market consternation:

Participants had an initial discussion about the appropriate conditions and timing for starting balance sheet runoff relative to raising the federal funds rate from the ELB. They also discussed how this relative timing might differ from the previous experience, in which balance sheet runoff commenced almost two years after policy rate liftoff when the normalization of the federal funds rate was judged to be well under way. Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate. However, participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience. They noted that current conditions included a stronger economic outlook, higher inflation, and a larger balance sheet and thus could warrant a potentially faster pace of policy rate normalization.

That’s pretty specific. Although everyone assumed runoff would commence sooner after liftoff than it did during the last cycle, the explicit nature of the language conveys a desire (on the Fed’s part) to drive home the message.

“Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode,” the minutes went on to say. A quick scan reveals multiple such mentions, all couched in similar language. For example:

Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate. Some participants judged that a less accommodative future stance of policy would likely be warranted and that the Committee should convey a strong commitment to address elevated inflation pressures.

There was a nod to the desirability of guarding against a repeat of the funding squeeze that played out in September of 2019. “Several participants noted that the level of reserves that would ultimately be needed to implement monetary policy effectively is uncertain, because the underlying demand for reserves by banks is time varying,” the minutes said. “In light of this uncertainty and the Committee’s previous experience, a couple of participants expressed a preference to allow for a substantial buffer level of reserves to support interest rate control.” The problem is that no one really knows what constitutes an adequate buffer.

As for rates, there was a sense of urgency, although I’m not sure I’d call it panic. “Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.”

It looks as though March is a go for liftoff. As soon as the accelerated taper unveiled last month (figure below) is complete, most officials are ready (or at least willing, depending on circumstances) to move on rates.

It’s now likely the Fed will try (and I emphasize “try”) to squeeze in two rate hikes by the time the taper would have ended on the original schedule. That speaks to the level of alarm vis-à-vis inflation outcomes.

All in all, the minutes skewed hawkish. No one should be surprised by that, but, again, I suppose I’d emphasize that the minutes were perhaps more explicit than expected regarding the runoff discussion, especially considering the debate took place at a meeting when the pace of the taper hadn’t yet been formally accelerated, even as a decision to move faster was a foregone conclusion.

“During the last cycle, it was 22 months between liftoff and balance sheet normalization. Given how compressed this cycle has been as the coronavirus quickly shifted from a growth to an inflation concern, it should come as no surprise the Fed is unwilling to take an overly cautious approach on the way out of an extraordinarily accommodative policy stance,” BMO’s Ian Lyngen and Ben Jeffery said Wednesday afternoon, adding that “in the wake of the minutes, a late-2022 or early-2023 timeline for balance sheet runoff is set to emerge as the consensus.”

The question now is how long it takes the market to force a dovish pivot which, in my estimation, is virtually guaranteed.

The market does seem to understand (and accept) that some tightening is necessary. It looks like the Fed wants to get it done fast in order to avoid getting trapped with no leeway to ease in the event the very act of normalization creates the conditions that make a dovish pivot necessary.

Once again, I’d remind you that even though “stocks aren’t the economy,” as the saying goes, falling equity prices and rising real yields represent a tightening of financial conditions, and it’s not a big leap from there to wider credit spreads. Once credit gets sick, it’s just a matter of time before policymakers are forced to abandon the ever elusive normalization quest.

Judging by Wednesday afternoon’s knee-jerk reaction to the minutes, you’d be forgiven for suggesting the Fed won’t even make it past the first rate hike before Powell is forced to start talking about how “flexible” policy can be.